Trading the Relative VIX 2

Adam Hamilton May 16, 2003 3074 Words

As the US stock markets continued their unnaturally serene and placid trading action this week, I found myself once again contemplating sentiment and volatility.

Sentiment, the collective emotions of all market participants, is the prime driver of financial markets over the short-term. Short-term market movements are like an endless sine wave of perpetually warring greed and fear. Speculators as a thundering herd first surge towards a frenzied greedy extreme with great zeal and then suddenly change course in a heartbeat and flee for their lives back towards a black abyss of fear.

The popular metaphor of the herd mentality in the markets is very appropriate, as these shifts in emotional sentiment near extremes of greed or fear, at major interim tops or bottoms, seem to suddenly occur in the majority of traders at the same moment with little or no warning. Like a perfectly synchronized school of individual fish, popular short-term speculation sentiment can rapidly shift in unison among individual speculators.

Emotion is hard to measure. How do you and I as contrarian speculators know when the thundering herd is too greedy, or too fearful? How can greed and fear be precisely quantified? Unfortunately emotions defy quantification, but fortunately there are excellent sentiment indicator proxies that adequately mirror overall emotional shifts in the thundering herd of speculators.

One of these indicators that is useful for reflecting popular emotions is market volatility, with extremely low volatility such as we are witnessing today a sign of widespread greed and complacency and extremely high volatility like we witnessed back in October a sign of spiraling popular fear and panic.

The ultimate way to measure volatility as a sentiment proxy is with the S&P 100 Implied Volatility Index, better known by its popular symbol VIX. I have written many essays analyzing the venerable VIX, both exploring its wonderful utility as a sentiment proxy and attempting to understand its limitations.

About a month ago in “Trading the Relative VIX ” I presented some of our research on the VIX attempting to adjust for its rising baseline within the context of this Great Bear market in US equities. Through a simple mathematical manipulation, the usual absolute VIX can be divided by its 200-day moving average to create what I coined the “Relative VIX”.

The Relative VIX is useful because it shows the current VIX levels in light of the relatively recent volatility background noise. I believe that the volatility encompassed in the past 200 trading days for the VIX is an important variable to consider when analyzing the VIX in general. Over many years the general volatility signature of the markets gradually changes, and the Relative VIX attempts to respect and account for these changes by also weighing the VIX’s 200dma in its equation.

As I threatened in “R.I.P. Great Bear? ”, this week we are continuing our investigations into the concept of the Relative VIX, delving much farther back into its voluminous historical data to see how this promising indicator has worked in the past. The results of these explorations are quite interesting.

Our first Relative VIX chart this week runs back to 1990, with the flagship S&P 500 stock index superimposed on top for visual reference. The big raw charts linked above do run all the way back to 1986 and showcase some interesting anomalies surrounding the fascinating Crash of 1987. but we could only comfortably fit data back to 1990 in these much smaller essay-sized graphs to keep them readable.

As speculators, we are interested in Relative VIX extremes and what happened in the S&P 500 in the weeks following these extremes. The big red center-mass Relative VIX around 1.0 above showing normal volatility levels is not important, just the major outliers to the upside and downside. These extremes mark the moments when traders can throw long or throw short to ride a high-probability speculation play.

Just as with trading the regular VIX, trading the Relative VIX depends upon going long on stellar Relative VIX highs and going short on abysmal Relative VIX lows. The Relative VIX inherits the VIX’s most wonderful properties as a fear gauge. Like the VIX, high Relative VIX levels signal extreme unsustainable fear, the very moment that daring contrarian speculators throw long against the sentiment extreme. Conversely, also like the VIX, low Relative VIX levels signal extreme unsustainable greed and complacency, the moment when contrarian speculators want to throw short against the thundering herd.

Each of these major Relative VIX extremes is marked and labeled on the graph above, with the red number showing the most extreme closing Relative VIX level achieved on each major peak or trough. The white number next to each peak or trough is the return of the S&P 500 stock index 10 trading days after each major Relative VIX extreme. The yellow number is the S&P 500 return 20 trading days after each extreme. These are raw absolute S&P 500 index returns, they are not annualized and not leveraged with options.

By analyzing the short-term 10-day and 20-day post-VIX-extremes performance in the S&P 500 over many years, we can gain a superior understanding of how well this indicator really worked historically. This exercise becomes even more interesting when we consider that the S&P 500 straddles a major long-term top in 2000 dividing bull and bear, so both a long-term secular bull market and a long-term Great Bear are included in this analysis.

The average extreme Relative VIX top marking widespread fear since 1990 runs about 1.85, meaning that the VIX tends to top about 85% above its 200-day moving average. The average extreme Relative VIX bottom signaling unsustainable greed and complacency has run about 0.70 in the past decade or so, or 70% of its 200dma.

These averages grant us a nice ballpark range to let us know when we should really start paying attention to this Relative VIX indicator. We decided to err a little bit on the conservative side at Zeal so we can attempt to catch these extremes in the future a little earlier rather than later in real-time.

In both our Zeal Intelligence and Zeal Speculator subscription services, we are currently running a Relative VIX long-to-short range of >1.75 to <0.75 based on the chart above. If the Relative VIX approaches 1.75 or higher, we want to be closing out our shorts and puts and going long. If the Relative VIX approaches 0.75 or lower, we want to be closing out our longs and calls and throwing short. The Relative VIX helps us decide when to make our trades so we can speculate against prevailing emotions as contrarians.

How would this speculation strategy have fared historically? The graph above offers some answers. Let’s start by examining the Relative VIX extreme tops. since the VIX is most famous and accurate as a proxy for general fear in the markets.

The average absolute return in the S&P 500 10 trading days after all the major Relative VIX tops marked above weighed in at 5.5%. 20 trading days after these tops, this S&P 500 average return was 7.1%. In the past 13+ years a speculator watching for high Relative VIX extremes could have thrown long the S&P 500 itself and earned about 5.5% in 10 days or 7.1% in 20 days, very impressive numbers for such short periods of time. Obviously these gains could have been further leveraged with derivatives such as index call options.

It is really interesting and intriguing that these Relative VIX tops heralded exclusively positive 10d and 20d returns both in a major bull and major bear market! Just like the ultimate bull-market buy-and-hold strategy will ruin someone in a bear market, the rules for some sentiment indicators actually invert if a bull market changes into a bear. Indicators like the Relative VIX that work well in both market types are relatively rare and great to find!

Since this Great Bear won’t last forever (it’s not over yet though!), it is exciting to lay the initial foundation work for bull-market trading signals that we can use in the future after the ultimate undervalued Great Bear bottoms are finally reached in the coming years.

While the Relative VIX tops signal works fine in both the bull and bear, it seems more potent in a brutal bear-market environment like the one we face today. The S&P 500 long-term top in 2000 is readily apparent above, and marks the fabled demarcation point between a secular bull and a secular bear. In the Great Bull before 2000, the average 10d and 20d S&P 500 returns after high Relative VIX extremes were 4.4% and 4.8%.

These numbers certainly aren’t bad and are definitely of tradable magnitude, but the performance off Relative VIX tops in a secular bear market like today’s dwarf the bull-market signals. Since the 2000 S&P 500 top, the index’s average 10d and 20d returns off of high Relative VIX extremes weighed in at an amazing 8.2% and 13.0%! It pays to throw aggressively long whenever the Relative VIX soars above 1.75 or so, but this signal is especially potent in a secular bear market.

Just like the VIX, the Relative VIX’s fear signals marking extreme popular fear and hence an imminent major bounce are phenomenally accurate. Speculators should always know where the Relative VIX happens to be trading at any moment in time.

Turning our attention to the Relative VIX bottoming extremes, the S&P 500’s average absolute 10d and 20d returns after these extreme greed and complacency episodes since 1990 was -1.2% and -2.6%. While there are several instances where the S&P 500 actually rose shortly after a major Relative VIX low, the markets tended to fall or trade sideways the vast majority of the time after these events.

Dividing the past 13+ years into secular bull and secular bear periods also yields some intriguing insights. In the Great Bull leading up to 2000, the average 10d and 20d S&P 500 returns after major Relative VIX lows were -0.7% and -2.0%. This is really fascinating to me as it seems to suggest that extreme greed and complacency as marked by unnaturally low Relative VIX levels is even short-term bearish in a mega-bull market! Sentiment is almost always the most powerful force behind short-term market moves, regardless of the long-term major bull or bear trend in play.

If we look at the extreme Relative VIX lows since the Great Bear began in 2000, the Relative VIX becomes an even more powerful signal to go short. The average S&P 500 10d and 20d absolute returns off these Relative VIX bottoms in the Great Bear were -2.5% and -4.1%. Short is the way to play the game whenever the Relative VIX plunges under 0.75 or so, especially in a Great Bear market like we are suffering through today.

Historically, through both major secular bull and major secular bear markets, the Relative VIX has proven to be a fantastic short-term index-speculation indicator. Stellar Relative VIX readings around 1.75 signal unsustainable short-term fear and hence the moment to throw long for a multi-week or multi-month trade. Dismal Relative VIX readings around 0.75 signal unsustainable short-term greed and complacency, the very time when contrarian speculators want to bet against the thundering herd and prowl on the short side.

Provocatively on this Monday May 12th, the Relative VIX plunged down to 0.62, amazing near-record-low levels not witnessed since the anomalous post-1987-Crash adjustment period! Other than that totally unique event of market history, the Relative VIX has never even approached such abyssal levels as witnessed early this week. On the graph above it is easy to see just how far down the Relative VIX has truly plunged today.

What does it mean? Well, as much as the insta-bulls want to ignore this historic market truth, extreme low Relative VIX readings signal a high-probability opportunity to short ahead of a market decline. The financial markets don’t like and will not tolerate extended episodes of rampant greed and complacency and corrections or downlegs shortly follow major Relative VIX lows in history.

Will this time be different? I doubt it, but the bulls sure seem to hope so! It will be interesting to observe the S&P 500 trading action in the coming weeks to see if this Relative VIX is once again signaling an imminent decline in the US stock markets. If you remain long the fading war rally. you ought to carefully consider the ramifications of this near-record-low Relative VIX warning signal!

The inane perma-bullish drivel saturating today’s airwaves aside, we are in a Great Bear market today so it is useful to zoom in on the current bear market to continue our historical Relative VIX explorations. The graph below is simply the bear-market portion of the long graph above, with the addition of 30-day and 40-day post-Relative-VIX-extremes absolute S&P 500 returns.

We also highlighted two more Relative VIX tops that didn’t quite make our 1.75 threshold but were nevertheless fairly close and worthy of note.

First, I can’t pass up a strategic S&P 500 graph without noting the painfully obvious steep downtrend in this all-important index. In the context of the entire Great Bear to date, the little war rally shown in the lower right corner still remains unimpressive and hasn’t even come remotely close to technically suggesting that the Great Bear has been eradicated. Let the bulls beware!

The immense danger of focusing exclusively on daily stock-index movements alone is that it can result in losing one’s crucial long-term strategic perspective. Please don’t make this lethal mistake by taking the war rally out of its proper context within the greater bear market.

As we witnessed above in the longer-term Relative VIX graph, this indicator has been even more potent in the bear-market environment. Major Relative VIX tops since the bear began have indeed signaled unsustainable fear and presaged significant short-term gains in the S&P 500. The average 10d, 20d, 30d, and 40d absolute S&P 500 gains off these extreme Relative VIX highs weighed in at a phenomenal 10.0%, 13.0%, 11.2%, and 12.5% respectively! These are very impressive short-term returns which illustrate just how important it is for speculators to be long when the Relative VIX approaches or exceeds 1.75 or so.

Similarly, extremely low Relative VIX levels in this bust to date have preceded ideal times to be short the markets. When implied volatility as measured by the VIX and scaled by the Relative VIX is too low, it signals popular greed and complacency that simply can not last at such lofty levels. Following these events in this Great Bear so far, the average absolute S&P 500 returns are exclusively negative. The 10d, 20d, 30d, and 40d numbers average -2.5%, -4.1%, -6.2%, and -6.0% respectively.

These high-probability losses off of short-term greed tops (Relative VIX bottoms) can be easily avoided by either selling out and sitting neutral for a month or two after such an event or actively shorting the indices. Once greed and complacency reach such extremes, the markets almost have to fall as the pendulum of popular sentiment begins its inevitable swing back towards fear.

Armed with some historical research on the Relative VIX, it has indeed proven to have been a powerful tradable sentiment indicator in both secular bulls and bears, but is particularly potent in bearish environments like today. Speculators ought to diligently monitor the Relative VIX so they can both take advantage of actively trading its strong signals and also avoid being caught on the wrong side of the greed and fear of the thundering herd.

Once again it is really important to take note of the incredibly anomalous abyssal Relative VIX lows witnessed this week. A Relative VIX reading of 0.62 is simply mind-boggling and unambiguously suggests that there is far too much greed in the stock markets today so a pullback is almost certainly rapidly approaching. Lots of bulls have chosen to ignore this ominous harbinger and stay long, and it will be interested to watch their fear explode in the coming weeks if the Relative VIX again proves true to form this time around.

With the S&P 500’s short-term war-rally support clashing with its long-term bear-market resistance, we are at a crucial inflection point. An average 20d absolute percentage decline in the S&P 500 after this Relative VIX sell signal, for example, would bludgeon the index back down to 906 and fracture its short-term support. And if short-term war-rally support fails, a much larger selloff could rapidly snowball as fickle momentum traders flee for their lives. We are at an exciting crossroads as speculators!

If contrarian speculation based on sentiment indicators like the Relative VIX interests you, I discussed many more elite sentiment indicators in the current May issue of our acclaimed Zeal Intelligence monthly newsletter. The technical mechanics behind the indicators are discussed and their historical long-to-short ranges are defined. The May ZI letter also shows where to go on the Web to find the status of any of these sentiment indicators, including the Relative VIX, at any time.

If you honor us with a new subscription to the $59 per year e-mail PDF edition of our newsletter today, we will promptly e-mail you a complimentary copy of the current May issue discussing these elite sentiment indicators. Your paid subscription won’t start until next month’s June issue, at which time we will update the status of these indicators we follow in our newsletters.

The bottom line is the Relative VIX has a long and distinguished track record as a contrarian speculation sentiment indicator. It should be carefully watched in both bull and bear environments, but especially in a Great Bear like today.

Sentiment is the prime driver of the markets over the short-term as the thundering herd perpetually vacillates between being generally greedy or generally fearful. The Relative VIX does an excellent job in acting as a proxy to quantify these warring emotions over a great deal of time.

Today’s abnormally low Relative VIX readings strongly suggest that greed and complacency have once again waxed far too extreme and a pullback is necessary to rectify this emotional overload.

Adam Hamilton, CPA May 16, 2003 Subscribe